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Tuesday, December 6, 2011

Discount Window Lending, Part III

As a followup to this post and this one, I think we finally have this sorted out. Some people were arguing that the Fed's lending to financial institutions during the financial crisis was subsidizing those financial institutions. But the bulk of lending was through the Term Auction Facility (TAF), and it appears that, if there was any subsidizing, that it had to occur through TAF. But, we have a record of all the loans made through TAF in the excel spreadsheet here. As you can see, the best deal that anyone was getting on a TAF loan was 0.20%, and all those loans occurred on January 2, 2009. Otherwise, the best deal was 0.25%, and no one could make a profit on that, given that the interest rate on reserves was 0.25% at the time, and the fed funds rate was lower than that, as were short T-bill rates.

So, was the Fed doing the appropriate thing? Maybe reading Lombard Street will help us? Fat chance. As Andolfatto can tell us, there's not a lot in Bagehot to go on. Bagehot tells us that the lender of last resort should "lend freely and at a penalty rate" during a crisis, which if anything seems like a contradiction. If you really want the banks to take the liquidity injection, you should not be penalizing them. Of course it makes sense that the Fed should not set up lending facilities which allow banks to simply make arbitrage profits, but that does not appear to have been happening during the financial crisis. Further, if the Fed was giving the posted collateral the correct haircuts, it was not taking on undue risk, and certainly the Fed does not seem to have come out on the short end of the stick on its lending. I have some too-big-to-fail moral hazard concerns, but that is about it.

The key question with these lending programs, as with any lender-of-last-resort lending, is why the central bank should not just buy the assets, instead of extending loans and taking the assets as collateral. I think the basic logic has to be that the central bank could buy the assets at their market price, but the market price is viewed as being inefficiently low. Instead, the central bank extends a loan for more than the market price of the collateral, and essentially takes the assets at a high price, temporarily. But, alternatively, the central bank could make an offer to buy quantity x of asset y at price p, and see how many offers come at that price. If total offers exceed x, then the central bank uses a lottery to choose.

Questions like this come up when we try to model how collateral is used in financial transactions. Indeed, I have never seen a satisfactory model of collateral. Basically, you have to explain why it is that someone who wants to borrow, and has an asset that they can use as collateral, does not just sell the asset. One can see how this works with mortgage lending, but in general it seems a difficult problem.

19 comments:

There is work by Kiyotaki and Moore that assumes collateral constraints and then works out some of the macro implications. Constraints like that are now used widely in work by Vincenzo Quadrini, for example, and my colleague Yongs Shin. But assuming the constraint does not get at the basic reasons for the use of collateral. There are some useful ideas in this paper, which is in the payments economics literature:

http://works.bepress.com/davidcmills/1/

Also, Aleksander Berentsen has some models (with coauthors) in the monetary theory literature that deal with collateral to some extent.

In general, though, this is an important avenue for study, and people have barely scratched the surface.

A possible answer to the collateral question- By using an asset as a collateral, we secure current liquidity as well as future liquidity. However, in case of selling the asset, the claim to future liquidity is forgone, even if current liquidity is taken care of. It looks like one of the implications of consumption smoothing under uncertainty.

"But the bulk of lending was through the Term Auction Facility (TAF), and it appears that, if there was any subsidizing, that it had to occur through TAF. "

Just as much lending was transacted through the Commercial Paper Funding Facility.

"is why the central bank should not just buy the assets, instead of extending loans and taking the assets as collateral."

I think this is just standard rick control. A collateralized loan is doubly protected in that it's a claim on the borrower's capital, and if the borrower fails, reverts into a claim on the submitted collateral. An outright purchase is singly secured and in that respect is more like unsecured lending.

This question about collateral is pretty retarded. If the price of the object is less than what I think its worth but I still want to liquidity then I borrow money by posting collateral.Furthermore, a person might have a strategic reason where control of the property is worth something to him but he still wants liquidity. Once again he borrows using collateral.

The big question at the time of a bailout is whether the distress is a problem of liquidity or solvency. Since these are more like two ends of a spectrum rather than two opposing sides of a coin, exactly where that line is drawn, by setting a price at which a LOLR will actually buy the assets, is a very tricky problem. Loaning money (against the assets) instead of buying them directly allows for a greater tolerance in setting the values.

For example, if the asset can sell at a fire sale price during the crisis of 20, but two years from now will sell for 40, then should the central bank pay a "fair" 20, a "fair" 40, or somthing in between? Even worse, nobody can really know for sure that it will sell for 40 when things calm down. Given the finality of a direct sale, any error cannot be corrected after the fact (c.f. AIG CDS). But if the central bank merely lends, say, 18, then it doesn't matter so much whether the "fair" value is 20 and the haircut is deemed to be 10%, or if the "fair" value is 36 and the haircut is deemed to be 50% - when the loan is due, the financial institution must pay back the 18 loan. Whether the "fair" value is 20 or 36 doesn't really matter so much in the short run, which is a pretty useful fudge.

And if you structure the direct sale so that it is not final; namely, that the central bank will agree to sell the bond back to the financial institution after the markets calm, then all that you have done is created a repurchase agreement - a repo loan.

What Wolfe said. E.g. If I own stock and have no available cash I might borrow on margin to be able to buy more stock. That way I have the opportunoity to profit from both assets. Are we missing the point?

I assumed collateral mitigated agency problems. If an asset is worth more to the borrower than to the lender, and the borrower knows better than the lender that he is unlikely to have to default (or if the ability to avoid default is in his control), he can borrow less than the asset is worth to the lender, secure in the knowledge that he is unlikely to have to surrender the asset. No?

Surely the reason that you borrow against an asset rather than selling it is for one of two reasons.

1) You get a convenience yield to maintaing ownership of the asset - for example housing as you said .

2) The other reason is specialized capital - the asset is more valuable in certain hands than other hands because of somebody's special skills. Thus it may make a lot of sense that I prefer to pledge the asset as collateral but maintain day to day use of it. Everyone else may prefer that as well.

"The other reason is specialized capital - the asset is more valuable in certain hands than other hands because of somebody's special skills. Thus it may make a lot of sense that I prefer to pledge the asset as collateral but maintain day to day use of it. Everyone else may prefer that as well."

Yes, exactly. There needs to be some asymmetry between the borrower and lender in terms of how they value the asset. But often the objects that serve as collateral are things that are highly "liquid," such as government debt. Look at the list of things that the Fed takes as collateral on discount window loans, or what serves as collateral in a repo transaction. Then, the special skills don't seem to come into play.

You would think that professor Williamson would know the literature a little better and would have read (and remembered), for example, Lacker RED 2001. This is starting to sound like a blog written from Boston.

No, I actually remember that well. I thought of mentioning it, but didn't think it applied to what I wanted to think about here. My memory (I have not read through it again) is that most of the action is built into preferences. But you're right, we should think about it, because it's instructive, if for nothing but to make the point that Lacker is a sharp economist. The Lacker paper is this one:

http://www.sciencedirect.com/science/article/pii/S1094202501901383

There is a story here. I actually refereed this, long before it was published in RED. Lacker sent it the the AER and I can't remember who the initial editor was. The paper was sent to me to referee, and I recommended revise and resubmit. Lacker submitted the revision, but by then the editor had left the AER and been replaced by Preston McAfee. For some reason Preston did not like the paper and canned it. It took 5 or 6 (or maybe more) years to get into the RED.

But government debt of a certain maturity may play a special hedging role if I'm holding it to back liabilities of the same maturity - for example if I'm a pension fund.

Then "special skill" is replaced with "special need" but the principle applies. I want to liquidate the asset, temporarily, without bearing any price risk so that I remain hedged against my liabilities.

Hence I am happy to repo the asset, not so happy to sell it and buy it back later.

Collateral is about the priority claims to assets. In a company with assets worth more than its aggregate debts at liquidation value there is no meaningful difference between unsecured and secured debts. In the cases of public companies that can sneak around on side deals without getting caught, unsecured loans and loan covenants not to borrow from people other than bondholders in large amounts assure repayment.

In privately held companies it isn't possible to monitor borrowing behavior and debts secured by collateral allow new lending to trump old debt in its claim against the company's assets and allows secured lenders to be assured that their claims won't be diluted by new debts that don't generate assets (e.g. to fund deferred executive compensation).

Asking why people don't sell assets rather than pledge collateral is asking the wrong question. The question is why people borrow money at all rather than sell assets. The answer to that question is simple. Leverage increases return on investment in a situation where you control the risk for the borrower, while allowing the lender to invest in a simple to enforce and understand transaction that doesn't take much monitoring and "voice" participation the way equity investments do. The equity cushion gives the borrower the right incentives to protect you until its gone. Collateral is just a way to set priorities and distinguish between higher and lower risk borrowing for people who have already decided to borrow money. It is the functional equivalent of a subordination agreement.